Valuing a Business

5. Price/earnings Ratio

The price/earnings ratio (P/E ratio) is the value of a business divided by its profits after tax.

Once you have decided on the appropriate P/E ratio to use (see below), you multiply the business' most recent profits after tax by this figure. For example, using a P/E ratio of 5 for a business with post-tax profits of £100,000 gives a P/E valuation of £500,000.

5.1 P/E ratios are used to value businesses with an established, profitable history.

• P/E ratios vary widely.

5.2 Quoted companies generally have a higher P/E ratio.

• A typical P/E ratio for a large, growing quoted company with excellent prospects might be up to 20.
• Their shares are much easier to buy and sell. This makes them more attractive to investors than shares in comparable unquoted business.
• Typically the P/E ratio of a small, unquoted company is 50 per cent lower than that of a comparable quoted company in the same sector.

5.3 Compare your business with others.

• What are your quoted competitors' P/E ratios? Newspapers' financial pages give historic P/E ratios for quoted companies.
• What price have similar businesses been sold for?

5.4 P/E ratios are weighted by commercial conditions.

• Higher forecast profit growth means a higher P/E ratio.
• Businesses with repeat earnings are safer investments, so they are generally awarded higher P/E ratios.

5.5 Adjust the post-tax profit figure to give a true sustainable picture.